Heading south

China has been home to the world’s most competitive export industry over the past decade. Its low-cost, low-value exporters have pumped out products ranging from textiles to electronics, in the process ushering cash into the economy and inflating China’s massive currency surplus.

But that competitive advantage has winnowed as the value of the renminbi and local wages increase. Labor prices in southern and eastern China, the traditional base of manufacturing, are growing at double-digit rates. This has prompted some manufacturers to move to China’s interior, where wages remain much lower; however, they often find those savings mitigated by higher transport costs.

As a result, many have speculated that production of these low-value items will trickle to nearby countries like Vietnam, Bangladesh and Indonesia. But in the age of international trade, production could move farther than that. Corporate decision-makers no longer have a clear-cut answer where to place their next factory, said Ivo Naumann, Shanghai-based managing director of consultancy AlixPartners.

“I need an additional plant because I’m running out of capacity. Do I put my next plant into China? Or do I put my next plant into Mexico?”

Overtaken overnight

Of all these possible destinations, Mexico may be the country to benefit most from China’s rising costs. Its products have among the lowest landed costs (meaning the total cost of a product once it arrives at the buyer’s door, including shipping and customs duties) of any manufacturing country, particularly for imports to the US. That’s partially because during the last five years Mexico has experienced very different economic trends than China has: The peso has depreciated against the dollar, and wages have risen roughly in line with the inflation rate.

For the first time in a decade, Mexico could give China stiff competition in the US market. Although the rest of Latin America is service- or consumption-oriented, Mexico manufacturers just about everything – clothing, electronics, cars and medical devices, to name only a few products – making it a natural competitor to China, particularly for exports to the US.

Alicia Garcia-Herrero, chief economist for emerging markets at Spanish investment bank BBVA, notes that competition between China and Mexico steadily ramped up toward the end of the last decade. The two countries now compete against each other in 26 of 30 product areas tracked by BBVA.

Mexico gained an early lead in the US market, thanks to its entry into the North American Free Trade Agreement (NAFTA) in 1994, which stripped away tariffs between the US, Canada and Mexico. Maquiladoras, Mexican factories that solely assemble products for export, sprang up in tremendous numbers as final assembly shifted away from the US.

But China’s entry to the WTO in 2001 turned the tide. Although tariffs weren’t entirely eliminated by China’s entry into the WTO, the drastic reduction was enough to bring China closer to the North American economy and draw manufacturing away from Mexico.

China’s entry to the WTO “changed the rules of the game of NAFTA,” said Enrique Dussel Peters, an economist and director of the Center for Chinese-Mexican Studies at the National Autonomous University of Mexico (UNAM). “This was not supposed to be; at least this was not expected by NAFTA.”

Between 2000 and 2010, China’s share of US imports doubled to reach about 19%, while Mexico’s share rose just 0.8% during the same period. China’s rise devastated some industries. For example, Mexico’s output of computers and peripherals was halved, and most domestically-owned factories in the subsector were wiped out, according to Peters. Mexico’s textile industry continued to grow, but was rapidly overtaken by China – at one point, the Chinese textile industry exported about nine times more to the US than Mexican factories.

“It was a no-brainer that China was much more competitive than Mexico,” Garcia-Herrero said. “This explains why Mexico has been losing [exports] for years and China has been gaining [exports].”

Reversal of fortune

But economists say China’s manufacturing dominance is now slipping as the trends that drove its competitiveness reverse. By some measures, Mexico has already caught up.

Mexico is now the global cost leader for manufacturing exports aimed at the US market, according to AlixPartner’s US Manufacturing-Outsourcing Cost Index, most recently revised in December. Manufacturing in Mexico costs roughly 75% of what it would in the US, compared to about 87% for China. Vietnam, Romania, Russia and India have also dipped below China in the last decade, at about 80% of US costs.

The rise in Chinese manufacturing costs can be largely traced to two factors: the appreciation of the renminbi and rapid wage inflation. China’s currency has gained 18% against the US dollar since 2005, driving up the relative price of Chinese goods. These trends benefited all of China’s competitors, but the effect on Mexico was further amplified by a 37% decline in the peso against the US dollar during the same period – effectively doubling the value of the renminbi vis-à-vis the Mexican peso.

Meanwhile, average monthly wages for workers at China’s factories quadrupled between 2000 and 2009, as a host of new economic opportunities around the country forced factory managers to compete with other businesses for employees. The shortage of low-wage workers has been particularly acute along China’s more developed coast. That has pushed companies into the interior, but it’s only a matter of time before they begin facing the same problem.

In the first nine months of 2011 alone, 21 of 31 provincial-level governments raised the minimum wage an average of 21.7% in an effort to boost domestic consumer spending and combat the country’s growing wealth gap. In contrast, wages in Mexico have grown at only around the inflation rate of 3%, Garcia-Herrero said. BBVA estimates that China’s average manufacturing wages surpassed Mexico’s in 2009; it now costs about US$360 a month to employ a Mexican manufacturing worker, compared to just under US$400 a month for a Chinese worker.

Companies that source their goods from China are already feeling the pinch. One Mexican importer of power tool accessories, who does business in China and asked not to be named, said that at the end of 2011 the price of one product he imports jumped by 10% within a month.

Weighing a move

The cost advantage of moving manufacturing from China to lower-cost countries like Mexico is clear. However, any wholesale shift will still be a long time coming.

Existing supply chains generate their own momentum. “The reality is that the underlying cost competitiveness certainly is a problem for China, and it is to the benefit of Mexico,” said Naumann. “But before you move such an ecosystem of suppliers to a whole different continent, it’s an effort of five or six years.”

This is because multinational companies look at far more than just landed costs when deciding whether to move operations, noted Klaus Meyer, a management professor at China Europe International Business School (CEIBS). The cost of labor in other countries must not only be lower than in China, but so low that business owners are willing to walk away from their current investments to build factories and venture into unfamiliar territory.

“[In] some industries if you set up a big factory [with] capital-intensive production – chemical industries or whatever – they’re pretty immobile,” Meyer said. “Exchange rates change a little bit, and you can’t just pack up and move.”

The first adopters, therefore, are usually companies looking to create new factories, with no “sunk costs” to influence their decisions. This is especially true for industries like textiles, which have lower training costs and le
ss capital investment, and can move more easily, Meyer said.

Unsurprisingly, this sector now seems to show some degree of change. China’s share of US low-end imports has purportedly peaked and is now in decline, according to UBS. The bank also predicts zero growth for overall Chinese exports in 2011.

But the picture is still one of rude health. China maintained 22% growth in worldwide exports in the first 10 months of 2011, with 14% growth in exports to the US, Naumann said. That growth has recently slowed, though this probably has more to do with slack demand from sickly European countries.

Several factors are likely to keep the export engine humming along for a while yet. Chief among China’s advantages is its huge pool of unskilled migrant workers, who can quickly and easily move in and out of companies to support seasonal production swings. “It’s like Christmas tree production: You sell 60% of the volume in four months of the year. What you need for that is these massive migrant worker pools of labor,” Naumann said.

China’s manufacturers also have access to much more capital than their Mexican competitors – sometimes by a factor of eight to 10, according to Peters. This can allow companies to rapidly expand production and achieve economies of scale.

And Mexico has its share of problems to give ambitious companies pause for thought, ranging from aggressive labor unions to the drug wars that have ravaged the country.

Joining forces

But rather than purely competing to attract new factories, China and Mexico could also stand to gain by investing in each other’s markets. It’s likely that many global supply chains will expand to include operations in both China and Mexico over the next few decades, and Chinese and Mexican companies should consider being among them.

“Is this a threat for China? I wouldn’t think this is a threat; in a sense, I would say this is much more of an opportunity,” Garcia-Herrero said.

Chinese firms could take advantage of the change in relative costs by building factories for the final assembly of goods in Mexico, the last step before export to the US. Mexico’s membership in NAFTA would help to greatly reduce tariffs and trade-related issues, Garcia-Herrero said. Chinese companies could consider the same arrangement for exporting to the EU, which has signed a free trade agreement with Mexico. Some of China’s most successful companies, including Lenovo and Huawei, have chosen to set up operations in Mexico, perhaps a sign of investment to come.

And as long as the US economy remains stagnant, Mexico also has incentive to invest in China to access its burgeoning consumer market. Mexican companies such as breadmaker Bimbo, tortilla maker Grumo, IT company Softtek and aluminum component manufacturer Nemak have already made plans to invest in China.

But as of now, two-way investment remains low. Peters estimates that China was responsible for only US$700 million of the US$20 billion in total foreign direct investment (FDI) that had flowed into Mexico by the end of 2010. Mexican FDI into China is estimated at about US$400 million. Official estimates, which often do not count investments routed through a third country, are even lower.

Melding together

Lackluster two-way investment can in part be blamed on political and cultural differences. Talks between the two countries on a strategic economic partnership have been slow and politics has been a stumbling block, Peters said. A 2011 meeting between the Dalai Lama and President Felipe Calderon incurred the usual scorn from China. And in 2009 Mexico alleged that China was unfairly quarantining its citizens, resulting in Mexico airlifting many of its citizens out of the country.

China and Mexico also remain “mutually ignorant” of each other’s economic opportunities. Training is part of the issue – few Chinese students graduate from college with a sufficient level of Spanish to seek out business opportunities in Mexico, and vice versa.

But for companies in Mexico and China, the process of integration may be inevitable. As firms become more global, they are increasingly demanding global supply chains that operate at the cheapest price. This is already beginning to happen in the automobile sector, where core suppliers in any country, Mexico and China included, will have to operate around the world to remain competitive, Naumann said.

“Very often [automakers] say look, if you want to be my supplier in North America, you also have to be able to supply me in China and Europe.”

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